Leverage (Finance)

Leverage is the use of borrowed money to buy an asset larger than your cash alone would allow. Cash on cash return exists because leverage makes the return on your equity differ from the return on the property. Without a loan, cash on cash return and cap rate are nearly the same number.

Leverage is positive when the asset earns more than the debt costs: the property's cap rate exceeds the mortgage constant, and each borrowed dollar adds to the return on your cash. It is negative when the debt costs more than the asset earns, and each borrowed dollar subtracts.

At 7.25% over 30 years the mortgage constant is about 8.2%. The default deal's 8.0% cap rate sits just below it, so leverage is slightly negative: 25% down returns 6.3% against 7.7% all cash, and 20% down returns 6.0%. At a 5% rate the constant is 6.4% and the same property has positive leverage. Leverage also magnifies appreciation and loss, which cash on cash does not measure.

Further reading: Leverage (Finance) on Wikipedia.